Sunday, July 11, 2010

BASEL II IMPLEMENTATION IN ZIMBABWE – CHALLENGES AND OPPORTUNITIES FOR THE LOCAL BANKING SECTOR

Introduction
Other countries especially in the developed world have made great strides in implementing Basel II over the past 8 or so years since Basel II was released by Bank of International settlements (BIS) in 2004. Countries in the European Union, Australia, the United Kingdom, Singapore, South Korea, Hong Kong, New Zealand and South Africa have already adopted Basel II’s Advanced Approaches for Credit Risk and Operational Risk and Advanced approaches for Market Risk. In comparison, Zimbabwe has lagged behind full implementation of Basel II.

Basel II has not been without its challenges with a lot of criticism coming in the wake of the recent subprime crises which have led to various players which include analysts, regulators and accountants asking the hard questions about the relevance of the Capital Accord in ensuring financial stability and adequate capital being held by banking institutions to cover losses commensurate with their risk profiles.

Background to Basel II
Although Basel II has been with around for a while, it remains unclear to some professionals in financial markets especially in countries where it has not been fully implemented. A brief background can assist in this regard. The Basel Committee on Banking Supervision was established by the central bank Governors of the Group of Ten countries at the end of 1974 and its secretariat is based in Basel. The Committee develops policy guidelines that each country's supervisors can use to determine the supervisory policies they apply.

The Basel Committee's most important work is in the area of setting minimum capital standards for banks worldwide. Supervisors have long sought to ensure that banks maintain adequate capital to cover all risks. In 1988, the Basel Committee agreed on the 'International Convergence of Capital Measurement and Capital Standards', more commonly known as the Basel Capital Accord or Basel I.

Basel II replaced Basel I in 2004 after regulators realised that there were some weaknesses in Basel I but it should be noted that essentially Basel II built upon the successes of Basel I. The objectives of Basel II: “International convergence of Capital Measurement and Capital Standards: A Revised Framework” were:
to continue to promote safety and soundness of the banking system through maintenance of the current overall level of capital;
to provide a comprehensive approach to measuring different banking risks;
to continue enhance competitive equality;
to increase the effectiveness of operational risk quantification;
to better align regulatory capital to underlying risks;
to promote a national supervisory and regulatory process to ensure the maintenance of adequate capital;
to increase the information integration across the whole business to manage market, credit and operational risks;
to provide incentives for banks to further improve their internal risk management systems; and
to focus on internationally active banks but also suitable for banks of varying levels of complexity and sophistication.

Key differences between Basel I and Basel II are reflected below:
FOCUS
BASEL I
BASEL II
Risk measure
Single risk measure applied. Basel I mainly dwelt on providing capital for credit risk as lending was considered to be the predominant function of banks at that time.
More emphasis on banks’ own internal methodologies, supervisory review, and market discipline
Risk sensitivity
Broad brush approach
More granular and more sensitive to risks
Credit risk mitigation
Limited recognition
Comprehensive recognition
Operational risk
Excluded
Included

Flexibility
Adopted a one size fits all approach and this had unfavourable consequences on capital assessment.
Flexibility and menu of approaches in recognition of differences in sophistication between banks and countries

Basel II focuses on 3 pillars which are mutually reinforcing. These are: (a) Pillar 1 - minimum capital requirements, (b) Pillar 2 - supervisory review process and (c) Pillar 3 – market discipline.

Pillar 1: Minimum Capital Requirements - defines the minimum capital requirements for key banking risks, which seek to refine the standardised rules set forth in the 1988 Accord. It allows bank to adopt appropriate approaches, from a menu of options, to deal with Credit, Market and Operational Risks. This pillar links, to the extent possible, the amount of required capital to the amount of risk taken. The revised framework tries to match the regulatory capital as defined by regulators to economic capital as determined by banks’ internal processes.

In measuring capital adequacy, an institution needs to determine its Capital Adequacy Ratio. The Capital Adequacy Ratio (CAR) is the ratio of regulatory capital on the liability side of the bank’s balance sheet to the sum of the bank’s risk-weighted assets. According to Basel I and Basel II this ratio must be at least 8%[i].

Buildig upon the foundation of Basel I, Basel II introduced three distinct options for the calculations of credit risk, market risk and operational risk which is important for determining a bank’s risk-weighted assets.

Credit Risk
Operational Risk
Market Risk
Standardised Approach
Basic Indicator Approach
Duration
Foundation IRB Approach
Standardised Approach
Earnings at Risk
Advanced IRB Approach
Advanced Measurement Approaches (AMA)
Value at Risk

Pillar 2: Supervisory Review Process - defines the supervisory review of an institution's internal assessment process and capital adequacy (ICAAPs). The review not only ensures that the banking institutions have adequate capital to support all the risks in the business, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. This pillar allows supervisor-bank dialogue on the measurement and management of risk and the connection between risk and capital.

Management of capital is important for both regulators and banks including accountants. IAS1:134, Presentation of Financial Statements requires an entity to disclose information in the financial statements that enables users to evaluate the entity’s objectives, policies and processes for managing capital.

Pillar 3: Market Discipline - details minimum levels of public disclosure, leading to greater transparency and accountability from bank management. This pillar aims to strengthen market discipline as a complement to supervisory efforts by increasing the transparency of a bank’s risk-taking activities to the customers and counterparties that ultimately fund and hence share these risk positions.

Already there is talk about Basel III after regulators and financial services sector participants noted some weaknesses in Basel II in light of the subprime crises of 2007 to 2009. This only shows that risk and capital management practices evolve over time and key lessons learnt from various economic and global developments will always influence the reactions of regulators, standards setters and politicians in addressing emerging challenges.

Progress made in Basel II implementation in Zimbabwe
Zimbabwe has lagged behind full implementation of the Accord although a lot of progress has been made in gradual implementation of components of the 3 pillars of Basel II[ii]. Recently, the Reserve Bank of Zimbabwe published a Technical Guidance on Basel II implementation in Zimbabwe in April 2010 soliciting comments from market participants and other players such as auditing firms and analysts.
This guideline outlines the methodology and requirements for implementing Basel II in Zimbabwe. It deals with definition of capital, the calculation of the minimum capital requirements (Pillar I) for credit risk, operational risk, and market risk; supervisory review (Pillar II) and market discipline (Pillar III). Definition of capital is quite key with regulators setting caps for various components of capital. This sometimes causes challenges with accountants not agreeing to the various caps and definitions of Tier 1, Tier 2 and Tier 3 capital[iii]


Challenges for the local financial sector in implementing Basel II
Implementation of Basel II in various countries has been associated with a number of challenges associated with any large project implementation process. Fully aware of the practical aspects of implementing a more modern, complete and risk sensitive prudential framework, the Basel Committee published, in July 2004, i.e. directly in the wake of the New Capital Accord, a document entitled “Implementation of Basel II: practical considerations”[iv].

Already the Technical Guidance issued by the Reserve Bank of Zimbabwe[v] requires that the core capital of a banking institution should exceed 50% of the capital base of the institution. Although this is meant to strengthen the capital base of an institution, it might be a challenge for local financial institutions to meet these requirements.
An analysis of countries across the world that have fully or partially implemented Basel II has revealed that compliance with Basel II is fraught with the following challenges:
· Lack of resources and qualified personnel in modern risk modelling approaches: Banks are required to make relevant budgets for Basel II implementation and this should cover IT requirements and all the training requirements. In some instances banks have been hiring consultants to assist them with Basel II.
· It is a fact that there are few professionals in Zimbabwe with qualifications such as CFA, PRM and FRM which are important risk qualifications laying the foundation for easier implementation. Most of those that have acquired such have left the country in search of greaner pastures.
· Executive ownership and change management: Implementing Basel II will require high level management commitment and may require changes to risk management in any institution. Typically a project management team reporting to the Managing Director and the Board will have to be in charge of the implementation process. Hard questions on internal impact, customer impact, business impact, regulatory impact and market impact will need to be asked throughout the implementation process and post implementation.
· The complexity of the New Accord, as well as its interdependencies with other significant regulations, makes implementation of Basel II a highly complex corporate governance/risk management project necessitating a structured and disciplined approach[vi].

· High operational and compliance costs which favour large banks which are able to bear such costs and benefit from economies of scale.
· Non-availability of high quality data is a challenge to the effective implementation of Basel II. Lack of sufficient data negatively impacts on calibration and benchmarking of models. The uncalculated, over-estimated/underestimated risks can nullify the whole efforts of Basel II implementation.
· Limited reliability of the ratings done by rating agencies defeats the purpose of enhancing market discipline. Credit rating agencies have come under fire in light of the recent sub-prime crisis with some jurisdictions such as the US mooting the idea of regulating such rating agencies.
· Sector-specific implementation of Basel II: In many developing countries, only banks are required to comply with Basel II, and not other financial services providers such as securities firms and the insurance sector. The Technical Guidance on Basel II Implementation in Zimbabwe applies to both banking institutions on a solo as well as banking groups on a consolidated basis.
· Regulatory arbitrage in banking operations across jurisdictions. These arise because of different implementation time tables, different approaches to implementation and different interpretation of Basel II.
In Zimbabwe, post implementation period will involve both regulators and banks monitoring the use of the new approaches with the objective of optimising their major objectives from their different points of view.
Benefits and Opportunities of Basel II Implementation
Implementing Basel II in the local sector offers various benefits and opportunities for the local financial services sector.

Pillar 1 of Basel II stipulates down a specific calculation of regulatory capital to set against credit risk transfer transactions (such as securitisations and credit derivatives). This treatment set out in Basel II thus aims to ensure that securitisation transactions have their own economic reality, rather than seeking regulatory arbitrage as was sometimes the case under Basel I.

Secondly, by reinforcing the link between the capital base and the risks actually incurred, Basel II encourages banks to improve their systems for managing these risks as well as their due diligence procedures.

Thirdly, Basel II gives banks and supervisors a vital tool, Pillar 2, with which to assess the risk profile of institutions and in particular to take account of certain risks that are sometimes difficult to quantify but whose impact can be great such as interest rate risk, refinancing risk and reputational risk.

Fourthly, Basel II sets out to promote stress tests as one of the tools for managing and assessing risks. Basel II stipulates that the stress tests conducted by banks must incorporate the effects of a large increase in credit and market risks as well as those of a rise in liquidity risk. The aim is to ensure that banks hold sufficient capital to absorb severe shocks.

Lastly, Basel II aims to substantially reinforce transparency and market discipline. Pillar 3 of the framework lays down numerous requirements regarding the disclosure of qualitative and quantitative information about capital and risk, including in respect of risk transfer transactions.
Overally, Basel II, will assist banking institutions to better assess and manage risks linked to securitisation transactions and to improve their financial reporting, two crucial areas in which the 2007-2009 global financial crisis have highlighted that significant progress needs to be made.
Conclusion
With the rapidly changing developments in global financial markets and financial innovation, local financial institutions will need to continue investing in robust management of capital, improving risk management structures and practices commensurate with their risk appetite.

There are significant benefits for the local sector in implementing Basel II and to this end open comunication on implementation issues and challenges between the sector and the Reserve Bank of Zimbabwe will be important going forward.

Banks with international presence will find it easier to implement Basel II in Zimbabwe by sharing information with their peers in other parts of the world therefore benefiting from economies of scale.

The local market and regulators will need to continue monitoring developments and ammendments to Basel II issued by Bank of international settlements (BIS) to ensure timely adjustments are done to the local sector.

References:
[i] Bank of France (November 2003), Financial Stability Review, Financial stability and the New Basel Accord.
[ii] Reserve Bank of Zimbabwe (January 2009), Monetary Policy Statement, Page 55.
[iii] PricewaterhouseCoopers (April 2010), Responses to Basel Committee on Banking Supervision: Consultative proposals to strengthen the resilience of the banking sector.
[iv] Bank of France (December 2007), Speech by Governor of the Bank of France before the Bank of Algeria and Algerian Financial Community.
[v] Reserve Bank of Zimbabwe (April 2010), Technical Technical Guidance on Basel II Implementation in Zimbabwe.
[vi] KPMG (2003), Basel II, A Worldwide challenge for the Banking Business.

Dony Mazingaizo, ACCA, has interest in IFRS and financial management.

2 comments:

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